4 February 2014 WHAT S HOT? EMIR : a reform in progress Frequently considered as remote and blurry, obligations enforced by European rule EMIR are gradually implemented. Countdown has well begun and is not restricted to OTC derivatives. It has been already four years since Pittsburgh s G20. Four years since it stated that "All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest." If some technical details are still yet to come and some questions remain, EMIR s new obligations are progressively coming into force and Asset Management players must comply with them. EMIR affects (almost) every one As its name tells, EMIR (European Market Infrastructure Regulation) is a European regulation. In this regard, it applies to every entity established in Europe and dealing derivatives, and also applies indirectly to non-european entities dealing derivatives with a European counterparty. If the vast majority of EMIR s obligations concerns OTC derivatives, both exchange-traded and OTC-traded derivatives must be reported to central repository. Quick reminder of the main obligations. Central clearing Derivative contracts deemed eligible will need to be centrally cleared by a central counterparty thus adopting operationnal processes very close to listed derivatives operation: - a Central counterparty (CCP) gathers all deals ; - Counterparties of the deal access the CCP via clearing members ; - an initial margin is required for every new contract ; - changes in market conditions affect the valuation of contracts and cause regular margin calls. Risk mitigation techniques In order to mitigate risk, uncleared OTC trades retain a bilateral treatment complemented with a new framework. Indeed, EMIR impose : - reduced confirmation periods ; - daily valuations of contracts ; - reconciliation procedures (of which the terms must be defined with the counterparty before signing any new contract) ; - portfolio compression procedures (to net crossed positions) ; - procedures for disputes management (again, prior to the signing of any new OTC contract) ; - sufficient levels of collateral reflecting the changes in contracts valuations. Reporting to trade repositories All counterparties need to report details of any derivative contract (OTC or exchange traded) they have concluded, or which they have modified or terminated, to a registered or recognised trade repository (TR) under the European Markets Infrastructure Regulation reporting requirements 1. This has to be done within one working day, in the name of the Asset Management company when acting as a counterparty in the deal. In practice, it will more frequently concern directly the UCITS or AIF managed by the Asset Management company as it is generaly the real counterparty. A phased implementation The implementation of the various obligations of EMIR is progressive and so is the implementation of reduced confirmation periods (as illustrated below) for non-eligible contracts while daily valuation of OTC derivatives is required since March the 15 th 2013 and other risk mitigation techniques came into force in September IRS / CDS Confirmation deadlines D+2 D+1 Other D+3 D+2 D+1 08/31/13 02/28/14 08/31/14 Notable exception, the date of entry into force of collateral exchanges for non eligible contracts is still to be determined in conjunction with the work of the Basel Committee and IOSCO (International Organization of Securities Commissions) published in September These documents suggest a progressive set-up between December 2015 and December 2019 and ESMA is currently working on the first draft technical standards. 4

5 February 2014 The date of entry into effect of the compensation obligations for eligible contracts also remains to be defined. Indeed, entities applying for the role of CCP will be formally approved not later than March 15, 2014 which should enable operational implementation in the second half of The list of eligible OTC derivatives will be defined by ESMA in accordance with the standardization of contracts, the assessment of business processes, volumes and ease to value. In addition to the types of contracts that ESMA will set ("top-down" process), the CCP will also be able to suggest new categories of contract in a "bottom-up" scheme. Recall that pending the entry into force of the clearing obligation, all OTC contracts must comply with the requirements for non-eligible derivatives, according to their respective schedules. Trade Repository Reporting : obligation an immediate The list of trade repositories (TR) registered by ESMA has been published since November: TR DDRL (DTCC) KDPW Regis-TR S.A. UnaVista Limited CME TR ICE TVEL Asset classes Commodities, credit, equities, interest rates This triggered the countdown to the entry into effect of the reporting requirement set for February 12 th From this date, information to provide TRs regarding OTC and listed derivatives include stakeholders (a specific identifier is provided), the type of contract, maturity, nominal, price and settlement date. Technical and operational impacts may prove costly In order to be compliant, the Buy-Side had to revise its master agreements, legal documentation and operating procedures. If this is not done yet, these adjustments should be coordinated with new IT investments combining reliability, auditability and productivity gains (automation of information exchanges, access to confirmation platforms, reporting, etc.). To anticipate the implementation of the clearing obligations, management companies - that have not already done so - should quickly choose their clearing members, a cumbersome and time-consuming burden that sould not be underestimated. The service offering, the list of accessible CCPs, experience, rating, reporting system and margin requirements should be part of the basic criteria to select a clearer. "Comply with EMIR is an expensive process both in terms of human and capital investments. For some organizations it will not be profitable to adapt for just a few OTC transactions per year. In addition, some investment funds will not have the sufficient eligible collateral to pursue strategies using intensively OTC swaps, such as some formula funds." Alain Le Gall, SAGALINK Consulting, Manager In addition to direct compensation, EMIR regulation also recognizes indirect compensation ie via a client of a clearing member. This allows, for example, Securities Services players that did not wish to become self-clearing members, to provide services of indirect compensation to their existing customers. In practice, it seems that the clearers are not ready yet to leave this possibility to their direct clients. Indeed, they argue that the current regulations do not give them a clear view on the risks associated with indirect customers. Leveraged implication of the collateral management function In the medium term, obligations introduced by EMIR will prove very costly : by imposing relationships with new suppliers, new practices both time-consuming and dataconsuming, imposing (indirectly) software developments. But they will also significantly increase the needs for assets eligible to collateralization. For this purpose, the likely list of eligible assets consists of cash, high quality government or corporate bonds, gold and equities of the main indices. Haircuts will of course apply to adjust to the risk of the collateralized asset and according to its currency. The assets received as collateral may, under certain conditions, be reused. However, it is important to note that funds will be considered as counterparties, not the AM companies that manage them. To prevent unexpected unwindings, asset managers will have to rely on a collateral management service able to anticipate needs in collateralizable assets, adjust collateral to the counterparties requirements and, if necessary, proceed suitable transformations. Ultimately, a cost-benefit analysis of the use of OTC derivatives in portfolio management is a necessary step to decide the appropriate strategy. "Asset managers will face an increase in their operating expenses and will need to acquire new skills. Only a detailed analysis of their use of OTC derivatives will enable them to assess the impact of EMIR on their organization as a whole and determine the relevance of maintaining certain functions internally." Thierry Decourrière, SAGALINK Consulting, Founding Partner 5

6 February 2014 Prerequisite Pros In-house Data management efforts IT investments Developped modeling expertise Connection to confirmation platforms Internal valuation skills (can be useful during the portfolio construction process) Improved risk perception 3rd party Sufficient asset-class coverage Documented processes Full transparency from deal initiation to deal termination (including data used for valuation purposes) Experienced OTC dedicated team Mutualized IT investments Scalability Ability to manage new asset classes Cons Data access (e.g. for non observable data) Staffing efforts (implied by new valuation frequency) Ability to quickly transform assets for collateralization purposes Externalized expertise 1 2 Cf. Contact us SAGALINK Consulting performs a regulatory and strategic intelligence. Details of EMIR and its implications have been studied since the first regulatory publications, which allowed the firm to develop a specific expertise in the treatment of OTC derivatives. SAGALINK Consulting is a consulting company, specialised in asset management, asset servicing, insurance and private banking industries. Our ambition is to combine our technical and operational expertise with a tailored consulting approach. Do not hesitate to contact us for additional information on this newsletter. We will be happy to share our views and insights on the topic. SAGALINK Consulting 18, boulevard Montmartre Paris Alain Le Gall Thierry Decourrière 6

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